The following is an excerpt from chapter three of my upcoming IB Economics Textbook published by Pearson Baccalaureate

Understanding price elasticity of supply, which measures the responsiveness of producers to changes in the price of different goods, allows firm managers and government policymakers to better evaluate the effects of their output decisions and economic policies.

Excises taxes and PES: A tax on a particular good, known as an excise tax, will be paid by both the producers and the consumers of that good. When a government taxes a good for which supply is highly elastic, it is the consumer who ends up bearing the greatest burden of the tax, as producers are forced to pass the tax onto buyers in the form of a higher sales price. If the producer of a highly elastic good bears the the tax burden itself, it may be forced to reduce output to such a degree that production of the good becomes no longer economically viable. A tax on a good for which supply is highly inelastic will be born primarily by the producer of the good. The price paid by consumers will only increase slightly while the after-tax amount received by the producer will decrease significantly, but in the case of inelastic supply this will have a relatively small impact on output. A graphical representation of the effects of taxes on different goods will be introduced in chapter 4.

Price controls and PES: A common policy in rich countries aimed at assisting farmers is the use of minimum prices for agricultural commodities. The European Union’s Common Agricultural Policy (CAP) involves a complex system of subsidies, import and export controls and price controls, the objective of which is to ensure a fair standard of living for Europe’s agricultural community. The use of minimum prices in agricultural markets can have the unintended consequence of creating substantial surpluses of unsold output. Take the example of butter in the EU. The following excerpt was taken from the January 22, 2009 issue of the New York Times:

“Two years after it was supposed to have gone away for good, Europe’s ‘butter mountain’ is back… Faced with a drastic drop in the [demand for] dairy goods, the European Union will buy 30,000 tons of unsold butter. Surpluses… have returned because of the sharp drop in the [demand for]… butter and milk resulting partly from the global slowdown.

In response, the union’s executive body, the European Commission, said it would buy 30,000 tons of butter at a price of 2,299 euros a ton… Michael Mann, spokesman for the European Commission, said that the move was temporary but that if necessary, the European Union would buy more than those quantities of butter — though not at the same price.”

The situation in the European Union butter market can be attributed to an underestimate by policy makers of the responsiveness of butter producers to the price controls established under the CAP. A minimum price scheme of any sort, if effective, will result in surplus output of the good in question, but the 30,000 tons of unsold butter in Europe appears to exceed the expected surplus considerably. The graph below illustrates why:

A price floor (Pf) is set above the equilibrium price of butter established by the free market. Butter producers in Europe are guaranteed a price of Pf, and any surplus not sold at this price will be bought by the European Commission (EC). Assuming a relatively inelastic supply, which corresponds with the short-run period (Ssr), the increase in butter production is relatively small (Qsr), resulting in a relatively small surplus (Qsr – Qd). In the short-run, the amount of surplus butter the EU governments needed to purchase was minimal. But as we learned earlier in this chapter, as producers of goods have time to adjust to the higher price, which in the case of the CAP is a price guaranteed by the EC, they become more responsive to the higher price and are able to increase their output by much more than in the short-run. Slr represents the supply of butter in Europe after years of the minimum price scheme. As demand has fallen due to the global economic slowdown, butter producers have continued to produce at a level corresponding with the price floor (Pf), leading to ever growing butter stocks and the need for the EC to spend, in this case, 69 million euros on surplus butter.

Understanding the behavior of producers in response to changes in prices, whether due to excise taxes or price controls, better allows both firm managers and government policy makers to respond appropriately to the conditions experienced by producers and consumer in the market place and avoid inefficiencies resulting from various economic policies.

Discussion questions:

1. Explain why the price elasticities of both demand and supply of primary commodities tend to be relatively low in the short run and higher in the long-run.
2. Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.
3. Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries.

Related Unit: IB Economics Unit 4.7 – Balance of Payments

Topic: The Marshall Lerner Condition and the J-Curve

Learning Goals/Objectives:

• For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
• For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
• For students to evaluate the argument that a country will always benefit from a weaker currency.

Success Indicators:

• Students will present their PowerPoint presentations of their exchange rate research, explaining how elasticity, exchange rates, and the balance of payments are related.
  
• Students will be able to outline their answers to three IB Economics examination questions relating to the Marshall Lerner Condition
  

Test of prior knowledge:

1. Define ‘price elasticity of demand’ and explain how it is measured.
2. With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
3. Explain how the depreciation of a country’s exchange rate might affect its current account balance.
   IS THIS ALWAYS THE CASE?
4. How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?

Process: Students should work in groups of four

• Each group chooses two countries
  • US and Canada
  • Switzerland and Great Britain
  • Euro area and Japan
  • Brazil and US
• Complete three pre-readings:
  • From BizEd:
    The Marshall Lerner Condition and The Economic Effects of a Devaluation
  • From Welker’s blog: The Marshall Lerner Condition and the J-Curve
    
• Using Yahoo Finance, research exchange rate data from the two countries two years ago up to today.
• Use Yahoo’s software to create two line graphs plotting the value of Country A’s currency against Country B’s, and Country B’s against Country A’s. For example:

The exchange rate of US dollars in Australia

The exchange rate of Australian dollars in the US:

• Finally, Create a PowerPoint presentation of your answers to the following questions. Include in the presentation the graph of the exchange rates created in the step above.

Of the four members of each group, two should prepare the section of the PowerPoint answering the following questions from the perspective of Country A and two from the perspective of Country B

Country A: ____________________ and ______________________

Country B: ____________________ and ______________________

Questions the PowerPoint should answer:

1. What is the Marshall Lerner Condition? Why is it important to consider the price elasticities of demand for exports and imports when examining the impact of a change in exchange rates on the current account balance?
   
2. Describe two periods of time from your line graph: One in which your country’s currency strengthened and one in which it weakened against the other country’s currency.
   
3. Using your knowledge of economics, explain TWO factors that may have caused the changes you have identified.
   
4. Given the changes identified, what would you predict would be happening to your country’s current account of the balance of payments over the three periods you specified above?
   
   1. Period 1: _______________________
      
   2. Period 2: _______________________
5. For both the periods of change, explain the impact of the change in exchange rates on the following:
   
   1. a firm that imports its raw materials from the other country
      
   2. a firm that exports its finished products to the other country
      
   3. consumers who buy imports from the other country
      
   4. a firm that produces good for the domestic market and competes with firms from the other country
      
6. Consider the impact of changes in the exchange rate on amount spent on imports and the revenue earned from exports (and thus, the current account balance). Assume the following for the three periods from your chart:
   
   1. Period 1: The price elasticity of demand for imports is 0.35 and the price elasticity of demand for exports is 0.55.
      
      1. Import spending will __________________
         
      2. Export revenue will __________________
         
      3. The current account will move towards DEFICIT or SURPLUS (identify which)
         
      4. Is the Marshall Lerner Condition met? Explain
         
   2. Period 2: The price elasticity of demand for imports is 0.5 and the price elasticity of demand for exports is 2.6.
      1. Import spending will __________________
      2. Export revenue will __________________
      3. The current account will move towards DEFICIT or SURPLUS (identify which)
      4. Is the Marshall Lerner Condition met? Explain
7. Think about the period in which your country’s currency weakened. Assume that the currency remains weak. How would the balance on the current account change over time following the depreciation of the country’s currency. Draw a J-Curve and explain its shape, referring to your country’s currency.
8. Look at the following article: ‘How Far Will the Dollar Fall?’ by Richard W. Rahn.
   1. Explain how the fall in the dollar might help to reduce the US trade deficit.
   2. Assess Dr Rahn’s argument that taxation and regulation are the principle causes of the potential for the limits to growth in the world economy.

You’re now prepared to consider the elasticity implications for balance of payments. Test your own understanding of the Marshall Lerner condition by answering the following IB questions:

1. With reference to the Marshall-Lerner condition, explain how the depreciation of a country’s exchange rate might affect its current account balance. (Total 10 marks)
2. An economy is currently experiencing a deficit on the current account of its balance of payments. The government is considering either allowing the exchange rate to fall or reducing aggregate demand. Evaluate the relative advantages and disadvantages of these two policies. (15 marks)
3. Explain how, in theory, balance of payments deficits and surpluses on current account are automatically adjusted under a system of flexible exchange rates. Illustrate your answer using supply and demand analysis. (Total 10 marks)

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

The elasticity, or perceived necessity of different products can influence the decision to introduce a tax. In Russia, two products, Beer and Vodka are being looked at as a potential sources of new government revenue. A proposed increase in the tax duties on beer, will potentially increase retail prices by between 20-30%. An increase in the price of one form of alcohol (beer) could shift demand towards other close substitutes, such as vodka or home brewed spirits. Hopefully, increased tax revenue will support the government finances and in the long run, the money could be reallocated to treat alcoholism.

An Economist article from last week gives a good analysis of this issue. Russia is a country where people drink 30 litres of hard liquor alcohol each year, six times more than the average European. Alcohol taxes are a sensitive subject, and the implications complex, but they need to be addressed.

The Economist – Russia raises tax on beer: Sin-Tax Error

Discussion Questions:

1. “Pushing up beer prices is far more likely to encourage drinkers to swallow even more vodka.” What does this quote suggest, about the cross elasticity of beer and spirits in Russia. Use evidence from the article so support your explanation.
2. The Russian government is suggesting adding a tax to beer.  What effect do you think this will have on the market price and market quantity of beer consumed.
3. The government wishes to impose a tax on these products. Assume a specific tax is imposed on each product. Assume the demand for beer is relatively elastic and the demand for vodka relatively inelastic and draw two graphs to show the effect on consumers and the relative tax burdens.
4. Explain what the aim of introducing taxes on vodka and beer is. Evaluate if the taxes will achieve the aims of increasing government revenue and reducing the social harms related to alcohol consumption in Russia.

Previously I blogged about the decline in demand for natural gas and the resulting decrease in quantity supplied by gas producers:

Welker’s Wikinomics Blog  ’Disequilibrium in the market for natural gas

Professor John Whitehead over at Environmental Economics Blog took the liberty of calculating the price elasticity of supply (PES: a measure of the responsiveness of producers to a change in a product’s price) of natural gas. In this case, since the price of natural gas went down, producers decreased the quantity of gas supplied. Professor Whitehead simply found the price of natural gas, and the rest was easy, given the date from the original article:

“Amid an abundance of natural-gas supplies and soft prices, gas producers are starting to pull the plug. Chesapeake Energy Corp. said it will cut 6% of its gas production in September in response to low natural-gas prices.”

And the professor’s calculation of PES:

PES = (change in Q/Q)/(change in P/P)And the percentage change in quantity is 6% (“Chesapeake Energy Corp. said it will cut 6% of its gas production …”).

…natural gas is about $5.75. During the period Feb-July ’07 price was pretty stable at about $7.50.

So, change in P/P = (7.5-5.75)/5.75 = .30 or 30%

Therefore: PES = 6/30 = .2

Update: While going over this blog post with my AP Econ students today, we noticed that the calculations from professor Whitehead’s blog are actually incorrect. The PES for natural gas is NOT 0.2, as Whitehead showed. Here’s why:

The original price of NG was $7.50, and when the price fell to $5.75 the quantity produced by Chesapeake Energy fell by 6%. Whitehead’s calculations of the percent change in price are wrong because he divides the change in price by the new price, when he should have divided it by the original price. The numerator in the PES formula should be (5.75-7.5)/7.5, which comes out to -2.33.

The PES is therefore -6%/-23.3%, or  0.26

While supply is still inelastic, it’s not QUITE as inelastic as professor Whitehead’s blog indicated.

Discussion Questions:

1. With a price elasticity of supply of 0.26, how would you describe the responsiveness of gas producers to changes in price?
2. Do you think the PES for natural gas would remain 0.26 over time if the prices were to remain low? Why or why not?
3. What is the primary determinants of PES?

A Silver Lining? The connections between gasoline prices and obesity – by Charles Courtemanche

Here’s the abstract from a new study about relationship between gasoline prices and obesity (I know, weird, right?)

A causal relationship between gasoline prices and obesity is possible through mechanisms of increased exercise and decreased eating in restaurants. I use a fixed effects model to explore whether this theory has empirical support, finding that an additional $1 in real gasoline prices would reduce obesity in the U.S. by 15% after five years, and that 13% of the rise in obesity between 1979 and 2004 can be attributed to falling real gas prices during this period. I also provide evidence that the effect occurs both by increasing exercise and by lowering the frequency with which people eat at restaurants.

Given these numbers, you, my students, should be able to calculate the cross-price elasticity of demand between gasoline obesity. Crunch the numbers, what do you see? Is this research plausible or did this guys simply see the relationships he wanted to see to support his thesis?

Hat tip to Professor Greg Mankiw.

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How can a commercial like the one below decrease the price elasticity of demand for a product like Molson Canadian beer? After this extremely successful commercial was released in Canada, Molson’s share of the beer market increased by 3%, while that of Labatt’s its largest competitor, shrunk by 3%.

The factors that affect the price elasticity of demand for a particular good are:
S - substitutes?
P – proportion of income
L - luxury or necessity?
A - addictive?
T - time…

Discussion Questions:

1. How can a successful advertising campaign reduce consumers’ responsiveness to changes in price of a good like Molson beer?
2. Why is it in the interest of a firm like Molson to decrease the price elasticity of demand for its product?

Econ professor and blogger Tim Haab has posted a great story on market failure, efficiency and corrective taxes at his blog, Environmental Economics: I love when someone else does my work for me.

With appreciation, I re-post his blog here in its entirety. Tim’s “Questions to consider” are perfect for IB and AP Econ students to answer in their Market Failure unit. Read and answer Tim’s discussion questions in the comments:

Today’s Econ 101 topic–actually AED Economics 200 but same diff–the deadweight loss from taxes in otherwise well-functioning markets. In my neverending–futile?–attempt to stay current, I plan to use this example from today’s Wall Street Journal:

Senate leaders are considering new federal taxes on soda and other sugary drinks to help pay for an overhaul of the nation’s health-care system.

The taxes would pay for only a fraction of the cost to expand health-insurance coverage to all Americans and would face strong opposition from the beverage industry. They also could spark a backlash from consumers who would have to pay several cents more for a soft drink.

The Center for Science in the Public Interest, a Washington-based watchdog group that pressures food companies to make healthier products, plans to propose a federal excise tax on soda, certain fruit drinks, energy drinks, sports drinks and ready-to-drink teas. It would not include most diet beverages. Excise taxes are levied on goods and manufacturers typically pass them on to consumers.

…

The Congressional Budget Office, which is providing lawmakers with cost estimates for each potential change in the health overhaul, included the option in a broad report on health-system financing in December. The office estimated that adding a tax of three cents per 12-ounce serving to these types of sweetened drinks would generate $24 billion over the next four years. So far, lawmakers have not indicated how big a tax they are considering.

Proponents of the tax cite research showing that consuming sugar-sweetened drinks can lead to obesity, diabetes and other ailments. They say the tax would lower consumption, reduce health problems and save medical costs. At least a dozen states already have some type of taxes on sugary beverages, said Michael Jacobson, executive director of the Center for Science in the Public Interest.

Questions to consider:

1. How do you reconcile the seemingly conflicting goals of reducing soda consumption and raising revenues to pay for health care?
2. Which effect do you expect to dominate: reduction in quantity demanded due to higher prices or increased revenue from higher prices?
3. Assuming the market for sodas (pop around here) is currently working efficiently, what effect do you expect a new tax to have on consumer well-being, producer well-being, government revenue and total social welfare?
4. What role do the elasticity of demand and elasticity of supply play in your answers to 1,2 and 3?

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

The concept of cross-price elasticity of demand measures the responsiveness of consumers of one good or service to the change in price of another. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the concept of cross-price elasticity of demand. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). The principle of cross-price elasticity of demand says that when the price of a good like personal vehicular transport becomes more expensive (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Kite Powered Ship Sets Sail for Greener Futhre – Guardian.co.uk

A German engineer has given an old technology new life to help make trans-oceanic shipping greener and least costly.

A cargo ship pulled by a giant, parachute-shaped kite will leave Germany on Tuesday on a voyage that could herald a new “green” age of commercial sailing on the high seas.

The owners of the MS Beluga, a 462ft cargo vessel, will try to prove that modern steel ships can harness wind power and reduce their reliance on diesel engines.

During the journey from Bremen to Venezuela, the crew will deploy a SkySail, a 160 square metre kite which will fly more than 600ft above the vessel, where winds are stronger and more consistent than at sea level.

Its inventor, Stephan Wrage, a 34-year-old German engineer, claims the kite will significantly reduce carbon emissions, cutting diesel consumption by up to 20 per cent and saving £800 a day in fuel costs. He believes an even bigger kite, up to 5,000 square metres, could result in fuel savings of up to 35 per cent.

Here’s a thought… reduced fuel costs to trans-oceanic shipping companies should shift the supply of such services out, as the marginal cost of shipping falls. Greater supply will mean lower prices to customers demanding such services, moving downward along the demand curve, increasing the equilibrium quantity of trans-oceanic cargo journeys.

Question: Assume all cargo ships in the world eventually incorporate the sail technology, increasing the supply and reducing the price of shipping by an average of 20% and reducing the emission of greenhouse gases of vessels by an average of 20%. What would have to be true about the price elasticity of demand for trans-oceanic shipping in order for a 20% reduction in price to result in an overall reduction of greenhouse gas emissions by cargo ships? Depending on the answer to this question, this “green” technology could actually result in greater emissions of greenhouse gases by cargo ships.

Explain…

Consumers are interesting creatures to study. Economics offers us a unique set of tools for understanding the behavior of consumers in various markets. Elasticity is one of those tools, one which helps us understand how consumers will respond to the change in price of some goods more or less than others. Some of the questions about consumer behavior elasticity helps answer are:

• Why do governments place such huge taxes on cigarettes?
• Why did Apple cut the price of the new iPhone in half from the original one, despite the fact that it had so many new features?
• Why do movie theaters seem to raise their prices so steadily over the years, rather than doubling the price of tickets each year?

These and other questions can be answered by knowing something about the relative price elasticities of demand for the goods in question. Price elasticity of demand refers to the sensitivity of consumers to a change in price. For some goods, even the slightest increase in price will scare consumers away, while for others, price can go up and up and up and the quantity demanded won’t budge!

Here’s just one illustration of a good for which consumers are extremely sensitive to changes in price: Every autumn, around the city of Shanghai thousands of small farms harvest the Chinese watermelon, a small, green, juicy melon that looks and tastes the same regardless of which farm it came from. The farmers sell their melons to one of the hundreds of melon vendors who drive their big blue trucks into the city of Shanghai during about two weeks in October to sell the watermelons to the city folk who love their refreshing taste.

During the two weeks of the melon harvest, there are hundreds of blue trucks parked two or three per block all over the city. The hundreds of melon vendors sell an identical product, acquired at identical costs from thousands of farms using identical techniques for farming. In other words, the melon market in Shanghai during these two weeks is close to being perfectly competitive.

The price of melons is established through competition at something very close to the exact cost to the vendor of getting the melons into the city. Consumers know this, and therefore if one vendor tries to sell his melons for more than the equilibrium price, consumers will respond by buying NONE of that vendors melons. Conversely, if a vendor were to lower his price at all, rationally EVERY consumer would want to buy from that vendor, but since the price is already at the cost to the vendor, no vendor is able to lower the price without losing money. The outcome in the market for melons in Shanghai is that demand for melons is close to being perfectly elastic, meaning that consumers are completely sensitive to changes in price of watermelons.

Not all goods are like watermelons. In fact, for some goods demand is close to perfectly inelastic. Study the graph below, showing the relative elasticities of five different products, then answer the questions below in your comment!

Discussion Questions:

1. For which product is demand pefectly inelastic? Perfectly elastic? Unit elastic?
2. What relationship exists between relative slopes of demand curves and elasticity?
3. What are two characteristics of cigarettes that make demand for them inelastic?
4. What are two characteristics of heart transplants that make demand perfectly inelastic?
5. What are the characteristics of a good for which demand is perfectly elastic?

As Clinton Seeks Gas Tax Break for Summer, Obama Says No – New York Times

Times are tough for American consumers. Rising food and fuel prices have increased the proportion of household incomes that must be allocated towards these two necessities, both for which demand is highly inelastic, meaning that as their prices rise, the quantity demanded by consumers remains relatively high.

In response to the pinching of Americans’ pocketbooks, two presidential candidates are advocating action at the federal level.

Senator Hillary Rodham Clinton lined up with Senator John McCain, the presumptive Republican nominee for president, in endorsing a plan to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for the summer travel season.

Sounds like a good idea, right? If Americans are finding it burdensome to pay more at the pump, and the government can do something to relieve that burden, why shouldn’t they do it?

Let’s do a little calculation here: At 18.4 cents per gallon, how much per fill-up will Americans save?

I drive a ’94 Toyota pick-up, has a 15 gallon tank and gets notoriously poor mileage. I’ll save $2.76 per tank of gas I buy. I usually fill up my truck about once a week during the summer, meaning I’ll save that much each week. McCain wants to suspend the gas tax from Memorial Day until Labor Day, or for a total of about 12 weeks. If Clinton and McCain get their way, I could very well save as much as $33.12 this year! ASTOUNDING!! What a deal for Americans!

Clearly, repealing the gas tax will have only a minor impact on disposable incomes in America. Obama seems to understand this better than the other candidates:

Senator Barack Obama, Mrs. Clinton’s Democratic rival, spoke out firmly against the proposal, saying it would save consumers little and do nothing to curtail oil consumption and imports…

Mr. Obama derided the McCain-Clinton idea of a federal tax holiday as a “short-term, quick-fix” proposal that would do more harm than good, and said the money, which is earmarked for the federal highway trust fund, is badly needed to maintain the nation’s roads and bridges.

The decision to suspend or not suspend federal gas taxes is essentially a cost-benefit decision. The benefit? Well, apparently around $30 per driver, or about half a tank of gas, compliments of the US government. The cost? Read on…

The highway trust fund that the gas tax finances provides money to states and local governments to pay for road and bridge construction, repair and maintenance. Mr. McCain and Mrs. Clinton propose to suspend the tax from Memorial Day to Labor Day, the peak driving season, which would lower tax receipts by roughly $9 billion and potentially cost 300,000 highway construction jobs, according to state highway officials.

There you have it; $9 billion dollars and hundreds of thousands of jobs that won’t be created in order to put half a tank of gas in each American’s car, which if you think about it, will only lead to Americans driving more this summer. Repealing the gas tax may actually induce Americans who weren’t planning road trips to go ahead and take one, increasing the overall demand for gas and driving the price up to the level it would have been with the tax.

And what about the much needed government revenue the tax creates? Hillary has another plan for recouping that loss:

Mrs. Clinton would replace that money with the new tax on oil company profits, an idea that has been kicking around Congress for several years but has not been enacted into law. Mr. McCain would divert tax revenue from other sources to make the highway trust fund whole.

Clearly, Mrs. Clinton needs a refresher course in basic microeconomics. If she had paid attention in AP Economics (did she even take AP Econ?), Clinton would know that a tax on producers of a highly inelastic good such as oil can be passed almost entirely onto the consumers. In this case, the oil companies, when faced with additional federal taxes on profits, will respond by restricting output, which reduces overall supply in oil market, raising the price of the main input for gasoline. Higher input costs for gasoline refineries will reduce overall supply of gasoline, increasing the price paid by consumers at the pump, negating any price-reduction induced by the suspension of the gas tax.

Ultimately, all taxes are borne by the consumers of an inelastic product: gasoline in this case. Whether the tax is levied on drivers directly, or the oil companies “upstream” in the production process, the outcome is the same: supply is restricted and price is higher.

The suspension of a gas tax that only costs Americans $30 over 3 months appears to impose a much greater cost to society than benefit. At least Obama seems to understand the basic economic reasoning behind this fact.

Obama on State Gas Tax Suspension

Carbon tax bill in the mail – Canada.com

…then we’d be spared the naive statements that appear in our media and out of the mouths of our citizens when a basic economic principle plays itself out in the market place.

In Quebec, the provincial government levied a carbon tax on energy producers:

When the provincial government imposed the country’s first carbon tax last fall, it wanted producers to pay.

But just as oil refiners have already done, Gaz Métro started passing on the cost of the carbon tax (to consumers) this month.

Big surprise, right? Only in a market in which demand is perfectly elastic would the entire burden of a tax be born by producers, since raising prices at all would mean loosing all their customers. Clearly, electricity is not such a market, and given the inelasticity of demand for a necessity such as electric power, chances are a big chunk of the “0.67 cents per cubic metre of natural gas” tax placed on utilities is being passed onto consumers.

In market economies, tax incidence is shared between producers and consumers. This of course, is the way it should be. If the price stays low and output remains high, no externality has been corrected and just as much greenhouse gas will be emitted as before the tax. In order to decrease output to a more socially optimal level, the tax should be passed on to consumers, but also born by producers in the form of lower profits. Despite this economic reality, consumers still aren’t happy about it:

“I don’t care how much it is, even if it’s just half a penny,” said Leonard, a Laval resident who called to complain about his gas bill. He spoke on condition that his last name not be used.

“They said consumers would not pay for this – and now here we are, paying for it.”

Poor old Leonard… never got to take an economics class in school! If only everyone had taken AP Econ in high school, naivety like this could be avoided! Ask ol’ Leonard if he’s stopped using electricity due to the higher price, and I bet you can guess his answer. Why? Inelastic demand.

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by Annie Sung and Kristie Chung

Which do you prefer, the Wii? the XBox 360? the PS3? How about other video game consoles? Can you even think of any other video games consoles? Hmm… let’s see… how about the Sega? Wait, no, haven’t seen any of those in a while… what about the Atari? Oh, shoot, nope! Oh yeah, don’t forget the Caleco Vision (for the record, Mr. Welker’s earliest video game memory was of playing Smurfs on a Caleco Vision).

The fact is, today, the market for video game consoles has shrunk to three dominant firms: Nintendo, Microsoft and Sony. This podcast will investigate the video game console market, examine its characteristics, including the elasticity of demand for the different consoles, and conclude whether it exhibits the features of an oligopoly.

by Caleb Liao and Drew Venkatramen

Just how important is the caramel frappuchino to Starbucks? This podcast will explore the demand for a particular product from the ubiquitous coffee chain, a new branch of which has recently been opened across the street from Shanghai American School.

SAS students overwhelmingly favor the sweet, caramel goodness of the beloved Frappuchino, but how much would they really be willing to pay for already the steeply-priced beverage. At its market price of 32 kuai, customers seem to arrive in droves from the SAS campus; but could Starbucks do better by charging a higher price? What if they lowered the price, would it make a difference in their revenues? This podcast explores the market for the crowd’s favorite coffee beverage, the caramel frappuchino, and tries to learn something about demand, elasticity, and firm behavior in the process!

 SAS Economists Podcast #5: What does the Caramel Frappuchino mean to Starbucks?: Play Now | Play in Popup | Download

By Nicole Wong and Katherine Yang

Podcast number 3 investigates the competitive market among groups selling baked goods here at Shanghai American School. The annual Relay for Life requires teams to raise 5,000 RMB (equal to about $650) in order to enter in the Relay. The most popular method of raising this entry fee is through bakes sales. This means that the month or so before Relay for Life SAS enters its “bake sale season” when countless teams try and push their products on teachers and students alike.

This podcast will explore the nature of the market for baked goods at SAS, determine the elasticity of demand for baked goods, and explore the prospects for increasing profits among teams hoping to make an easy kuai in the month leading up to the Relay for Life.

If the image is off, right click on the viewer and click “zoom” and “full screen”

 Competition in the Baked Goods Market at SAS: Play Now | Play in Popup | Download

BBC.co.uk – News – Science/Nature – “Brits ‘adicted’ to cheap flights”

As we continue to learn economics, you’ll begin to realize more and more how important this field is to truly understanding how things in our everyday lives work. For example, how will people respond to the increase in a product’s price when the government places a new tax on the product?

Chapter 18 of our text discusses the implications of price elasticity of demand on governments’ decisions of what types of goods to place excise taxes on. Given an understanding of PED, we as economists understand that taxes will earn the most revenue for a government when placed on goods for which the PED coefficient is less than 1. In other words, revenue seeking governments should tax products for which demand is highly price inelastic, and avoid taxing products for which demand is highly price elastic. This just makes sense: when the price of an inelastic good goes up, consumers will respond very little, while an increase in the price of an elastic good will scare away a relatively large number of consumers, meaning a decrease in total revenue (tax revenue in this case).

In addition to elastic and inelastic price elasticity of demand, we also discussed today the theoretical existence of products for which PED is perfectly inelastic. In the article linked above, geographers from the University of Exeter in the UK share findings from a study that seem to indicate that PED for air travel in the UK is perfectly inelastic:

“The government raised air passenger duty in February, and the European Union is set to include aviation in its Emissions Trading Scheme (ETS), which could increase costs further.

But the Exeter research suggests price hikes would have a minimal impact.

‘We found that flying is quite embedded in peoples’ lifestyle choices,’ said Stewart Barr from the university’s Department of Geography.

‘And it’s not people on lower incomes taking these flights, it’s middle class people taking more flights to go on city breaks, and they can afford to pay higher prices.’”

According to the Exeter geographers, because “flying is quite embedded in peoples’ livestyle(s)…” the increase in price resulting from the new taxes should have “minimal” impact on air travel. When most people say “minimal”, what they are implying is “none”… in which case we as economists can translate the geographers’ statements as thus: “the price elasticity of demand for air travel in the UK is zero (or darn close to it!)”

Could this be true? Do you think air travel has a PED of zero? If so, what are the implications for airlines? What are the implications for travelers? Could the geographers be wrong? What about air travel makes demand for it so price inelastic? Discuss!!

Hat tip to Professor John Palmer at EclectEcon for the link to this article.

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Starbucks Raising US Drink Prices Next Week – Reuters.com

One of the first things that my jet lagged family noticed when we got back from San Francisco was that Starbucks had opened up around the corner from our house in Zhudi Town. Normally, my family travels far and wide to buy coffee beans at the Starbucks in Gubei or at the Portman because my husband Kevin, a sophisticated caffeine addict, needs his well roasted coffee. Now my husband can just walk down the street to find his fix. Let’s just say that he now is very happy. My kids, Maya and Cooper, are extremely happy too because when they walked into the Starbucks Café, some smiling ladies behind the counter gave each of them a free gift. The gift was small packet of yellow sculpting clay. So much for teaching them that there is “no such thing as a free lunch” early in life.

I, on the other hand, had a lot of unanswered economic questions running through my mind when we into the café, For example, why did Starbucks open up here in Zhudi? What would this mean for my favorite local joint, The Rendevous Café? Is competition always a good thing? And what about my core value of “think globally and buy locally”? All of these questions continued swirling around in my mind as I had breakfast (with nicely brewed tea) at the newly updated Rendevous Café. As we were eating, the local owners came by our table and personally welcomed us back from vacation. I commented on how nice the place looked and the owners told me that the updates to the restaurant were a response to the new competition from Starbucks and Johnny Moos. The owners looked a little worried. For a long time they have been the only place in town where locals and SAS faculty and students could stop by for a western breakfast, lunch, dinner or coffee. Now, there is real competition. Rendevous’ food is definitely good but can they survive with this competition?

I ran home (well, a little overstated) and got online to see if I could catch up on the latest information about Starbucks Inc. and their plans for China. I was amazed to learn that Starbucks had just announced,

“Starbucks Corp will raise U.S. prices on coffee, lattes and other drinks by an average of 9 cents a cup next week to help offset soaring costs for milk and other commodities, a spokesman said on Monday, July 23, 2007.The widely anticipated move marks Starbucks’ second price increase in less than a year and comes a month after the coffee shop chain’s chief financial officer warned it would be “very challenging” for Starbucks to meet the high end of its 2007 earnings forecast, in part because of rising dairy prices.”

Also it was noted on a Chinese business website that in China, Starbucks will increase the price of their coffee drinks by as much as 5RMB in Beijing and 3RMB in Guangzhou. Dessert prices will remain the same. That got me wondering again, what is going to happen if the price of coffee drinks go up just as this new Starbucks is taking off in Zhudi Town? Will people stop going to Starbucks because of the increase in the cost of coffee drinks?

So, Starbucks has arrived in Zhudi. I know that many people are really happy but I am not sure if it is time to say hooray just yet. We will have to let the free market forces go forth and let the chips fall where they may. I certainly hope that Rendezvous Café is still standing when all the chips have fallen.

Discussion Questions:

1. What economic forces brought Starbucks to Zhudi? Name them and graph them.
2. What kind of market structure do fast food/coffee restaurants have? Explain. How do they compete with each other.
3. Will an increase in price of Starbucks coffee drinks affect people’s decision to buy coffee from Starbucks? Why? Why not?
   
4. Is there really such a thing as a, “free lunch? Explain.
   
5. Can Rendezvous café survive given its competition?

Gas hits record high price for eighth straight day – May. 20, 2007

According to CNN.com:

“The run-up in prices is a big concern for store chains, according to the retailers’ trade group. Its survey of consumers released early Friday found the average consumer believes that the price of gas will reach $3.32 per gallon by Father’s Day… As a result, 40.2 percent of consumers are taking fewer shopping trips, while 37.9 percent told the survey they plan to shop closer to home.”

“To offset the effects of higher prices, more consumers are giving their wallets a little extra cushion by cutting back on discretionary spending or choosing to frequent retailers closer to home.”"

And this is a bad thing? To big chain stores, perhaps, but what about the neighborhood businesses (are there still any of those?) that will benefit after years of losing business to big box retailers like Wal-Mart and Home Depot? Consumers driving less may harm major retailers whose stores tend to be clumped together in mega shopping strips on the outskirts of towns, but surely the benefits of less driving outweigh the costs.

Fewer cars on the road mean less traffic, less noise, more space for cyclists, less hazard to pedestrians and children playing ball in their yards, cleaner air and a deceleration of global warming, more customers at neighborhood businesses, and perhaps even more quality time with family and friends (if we can assume less time shopping means more time with each other).

So if high gas prices result in so many improvements in our environment, relationships, communities and health, why are they such a bad thing? Perhaps because higher gas prices overburden the poor. Since fuel makes up a larger proportion of a poor family’s budget than a rich one’s, higher gas prices put a bigger dent in the disposable incomes of the poor than the rich. Economic theory would indicate that the poor’s demand for gas is more elastic than the rich’s, meaning that price increases are met with a greater decrease in consumption than someone for whom gas makes up a relatively small part of their overall budget. This, again, may not be so bad. Perhaps the poor will begin limiting their outings to those that are deemed most necessary (such as to and from work, school, child care or clinic) and cut back on unnecessary trips (such as to mall, the movie theater, the go cart track or the Wal-Mart across town). Less consumption may not lower overall standard of living when we consider that much of the consumption going on by Americans (rich and poor alike) is frivolous and ostentatious.

Even acknowledging the regressive nature of the burden of high gas prices, it still seems to me that higher prices are necessary to achieving a cleaner, healthier, better functioning society. The problem is, if prices are kept artificially high through price gouging, as the Democratic leadership in Congress seems to believe, then the full benefits of higher gas prices are being passed on to oil companies rather than society, as could be achieved with an effective gas tax.

CNN presents their own solution to the problem of high gas prices:

From higher taxes to more drilling, ways to cut gas prices – May. 10, 2007

1- Pass a carbon tax
2- Increase efficiency
3- Push alternatives
4- Require oil companies to make more gas
5- Build a gasoline reserve
6- Drill more oil

It’s too bad my AP class has finished for the year. I think a great quiz would be to hand them this list and ask, “What’s missing?” Anyone who’s completed a semester in a Principle of Microeconomics course should be able to get an A on such a quiz. Can you tell what’s missing? If so, please post your comment here. (Hint- fill in the blank: Supply and ______?_______)

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